What Are The 4 Main Asset Classes?

Asset classes are groups of similar instruments that behave similarly to each other. They can be bought or sold as part of an investment portfolio. Understanding the different asset classes and their properties is the start of understanding how to navigate the investment world. Most asset classes differ in characteristics and are often negatively correlated. Therefore they can be mixed to balance and diversify portfolios and matched to specific risk profiles. I will be discussing money market instruments, fixed income, equities, and funds as the 4 main asset classes.

Money market Instruments

Money market is the market for short term and higly liquid financial securities. These include:

Treasury Bills

Treasury Bills are short-term government securities usually issued for less than 90 days. They are usually sold at a discount to their face value and redeemed at face value. In other words, you pay less for them and receive the full value when it matures. The gain you receive is the difference between the discounted value and the face value. Treasury bills can be purchased in the UK from the following financial institutions that bid on behalf of investors. However, a minimum investment of £500k is required making this out of reach to a lot of ordinary investors. That being said, you can invest in treasury bills indirectly through a money market fund.

Certificates of Deposits

A certificate of deposit (CD) is a document issued by a bank that states the interest rate and maturity date agreed for cash deposits made. A negotiable certificate of deposit is called a bearers’ instrument because it can be bought and sold before maturity. Whoever holds the document at maturity receives the principal and interest. A certificate of deposit is like a time deposit because money is given to the issuer for a fixed term in return for interest. CDs are issued by banks and are very similar to fixed savings accounts.

Commercial Paper

A commercial paper (CP) is an unsecured promissory note with a maturity of 270 days or less. Commercial Papers are usually issued by large credit-worthy corporations. This is because you are effectively lending to a company when you obtain a CP. In return, you receive a promissory note that states when the loan will be repaid and at what interest. Therefore, the less creditworthy the issuer of a CP is, the higher the risk and interest rate and vice versa.

Some pros and cons of investing in money market securities

Pros	Cons
Inflation risk of money market securties is low due to it’s short term nature	Low return on investment compared to bonds and shares
No default risk for treasury bills	Can only be cashed out at maturity unlike easy-access savings accounts
Interest/return is usually higher than savings	You can only put away a lump sum in a TB, CP, and CD, unlike a savings account where you can add a regular amount.
Short maturity, so perfect for putting money that might be needed in the not too distant future	If investing through money market funds, fees will erode the already low return

Bonds

A bond is a security that represents a loan by an investor to an issuer (Government or Corporations) in return for a fixed interest (Coupon/yield) paid periodically and principal payment at a specific date. Government bonds are issued by the government and corporate bonds by companies. Bonds are given credit ratings by companies such as Standard & Poors and Moody’s based on the level of default risk. A high credit rating signifies low risk while a low credit rating signifies high risk. Low credit-rated bonds are referred to as junk bonds and carry a high-interest rate to signify the risk. Consequently, high/investment-grade bonds carry less risk than junk bonds. Bonds have different maturities ranging from 1-30 years.

Two important things to note about bonds include their relationship with interest/yield and their relationship with the stock market. When new bonds with a higher interest rate are issued, prices of similar bonds drop. This is because there will be a lower demand for the bond paying the lower interest as new investors will choose the bond paying a higher interest rate if other factors (e.g. time to maturity) are similar. Secondly, when bond yields are more attractive, investors tend to shift from the stock market to the bond market leading to lower stock prices.

Some pros and cons of investing in bonds

Pros	Cons
Bond carries lower risk than shares as bond holders will get paid before shareholders in the event that the issuer goes bankrupt	Rates of return are low compared to shares
Bonds provides higher returns than money market intruments	Low-grade also known as Junk bonds are risky
Most bond pay interest up to 2 times annually which is great for income investors.	Bonds are subject to interest rate risk due to fluctuations. When interest rates go up, the bond price goes down. It is is possible to lose money when this happens.

Equities

Equity shares, also known as stocks represent ownership in a company. When you buy a stock in a company, you receive a percentage of ownership.  In return, you receive dividends from the companies profit as well as capital gains to your investment if the price of the stock increases. There are two types of equity shares, ordinary shares or common stock, which represent a percentage of ownership in a company, and preference shares which have characteristics that make them similar to bonds. The holders of ordinary shares have voting rights and receive a share of the companies earnings in dividends while preference shareholders have no voting rights, receive a fixed dividend, and hold a claim to assets before ordinary shareholders but after bondholders. This means that If a company goes bust, bondholders will get paid first from the proceeds of liquidation, followed by preference shareholders, followed by ordinary shareholders.

Majority of the shares traded in the stock market are ordinary shares so many people will be more familiar with ordinary shares than preference shares

Some pros and cons of Shares

Pros	Cons
Shareholders participate in the growth of a company through higher prices or dividend payments	It carries a high risk, if a company goes bust, the shareholders (class A) are the last to get paid, that is if there is anything left
Shares historically have a higher rate of return than money market securities and bonds	When you hand in your money to buy shares, it is indefinite (unless someone buys it from you), unlike bonds where you get your capital back. It is important that the shares you buy are liquid and easy to sell.
A share gives you part ownership of a company. You will have voting rights that allow you have a say in certain decisions that the company makes	Share prices os stocks traded on the stock market are subject to market forces. It is not as straight forward as buy at a low value and sell higher. The value of a share can be affected by manipulation/news and irrational market participants. It is much easier to lose money because of this.

Funds

There are 2 main types of funds:

Mutual Funds

A mutual fund is a type of investment vehicle that invests funds pooled from investors in a variety of securities. Mutual funds are either open-ended or close-ended (also known as investment trusts). Open-ended mutual funds are the most popular and allow for people to buy in and exit the fund freely. Close-ended/Investment Trust funds on the other hand are smiliar to company shares as after you buy in you can only exit by selling your shares in a secondary market. Mutual funds are a great way to access professional portfolio managers and a wide range of securities.

There are so many types of funds including bond funds, money market funds, equity funds, real estate investment trusts,and balanced funds which hold a mix of assets. Also, there are funds following particular investment strategies, passive funds, active funds, growth funds. Some funds like the Vanguard Life Strategy Fund are designed to match risk profiles so you can pick one based on your risk appetite.

Exchange traded funds

Exchange-Traded Funds are similar to mutual funds except that you buy and sell them on an exchange at any time. ETF’s like mutual funds can mirror an index or hold different securities. So there are a good variety of ETFs that will cater to different investment profiles and strategies.

Funds charge a management fee which is called an expense ratio, some active funds have very high fees to reperesent the efforts of the funds manager in attempting to beat the market and provide superior return. It is important to watch out for high expense ratio funds to either ensure the results will be worth the cost and ensure they are not passive funds in disguise. This is because significant fund costs will reduce the return on your investments.

Some pros and cons of investing in funds

Pros	Cons
A very easy way to achieve diversification, therefore reducing risk	Some mutual funds have a high expense ratio
An affordable way to access professional portfolio management	The performance of the funds depends on the portfolio manager’s performance. There is a risk of losing money due to portfolio management
Easy way to invest in a basket of securities as you make one transaction instead of several	A lot of mutual fund investment policies are so generic it might be difficult to match individual needs. A self invested portfolio tailored to investor preferences might be superior in some cases provided you have the knowledge and skilss.

Conclusion

I have focused on these 4 main asset classes because they are the most common and relevant to anyone beginning to invest who wants to understand the main investment classes more. There are other asset classes like property which a lot will view as a traditional investment class but differ greatly in characteristics as well as alternative asset classes like hedge funds.

Series Navigation